The Private Equity Primer28/09/16
QUTEFS President Ryan Nolan writes about the dynamic field of private equity in this week’s edition of The Take:
If you have so much as a casual interest in finance, the chances are that you’ve probably heard of private equity. You might know them as vultures, sappers of your Superannuation Fund or the engineers of vital growth across all industries. You may recognise them as the monsters that collapsed Dick Smith or as the magicians that have transformed Ingham’s (yes, the provider of KFC’s chicken in Australia) into a $2 billion business.
Despite the poor press it receives in the broader media, Private Equity is unquestionably an integral part of the Australian economy, helping support over 500,000 jobs and adding nearly $60 billion in value each year (let’s not even get started on the fact that their returns are nearly double that of our Superannuation Funds).
Instead of adding to the multitude of opinion pieces already written about the industry, today’s Take will attempt to answer a few basic questions often neglected in the mainstream: What is private equity, and what do they do? What relationship does it share, and how does it differ from other finance streams? Finally, and most importantly as a student, how does one pursue a career within this mystical field? This article is by no means exhaustive and further reading is always encouraged via Wall Street Oasis, Vault Guides and the Australian Private Equity and Venture Capital Association.
What is Private Equity and what do they do?
Private equity firms, generally speaking, acquire majority ownership stakes in companies, or their divisions, with a view to improving the company over a set time horizon (usually 3-7 years) and then ‘exiting’ via an IPO or sale to a strategic buyer. The landscape is well displayed in the graphic from the British Private Equity and Venture Capital Association below.
Private equity firms are responsible for the identification and execution of investment opportunities. The firm receives management and performance fees from the fund (see below) but are also deemed General Partners (GPs) and thus are liable for its performance.
The private equity fund is the pool of funds invested by the firm. The firm will fill this pool with funds from Limited Partners (generally institutional investors protected by limited liability) and then invest it accordingly. It is not uncommon for large firms to have dozens of different funds, spanning multiple industries (e.g. Health Care, Industrials, Technology). The amount of funds in each pool is usually capped and a new fund is often opened once it has all been invested.
What relationship does it share with finance streams?
Private equity firms typically acquire companies utilising a large proportion of debt relative to the purchase price in order to maximise the amount of returns they can generate with the total equity (i.e. capital) in each fund. It is relatively common for a private equity acquisition to be funded with 70% debt and the remaining 30% coming from the fund. This has two important implications for their business model:
- PE firms typically work with large investment banks to fund the debt component of their purchase
- They generally aim to acquire companies with strong free cash flows and asset bases to cover interest repayments and provide lenders adequate asset security as for loan collateral
The firm usually looks for a target with genuine ‘upside potential’ over a short-to-medium term horizon. Once a suitable target has been identified, the firm will determine an optimal purchase price based off a Leveraged Buyout Analysis.
Once the acquisition is complete, the PE firm will usually appoint employees to strategic positions within the new company (For example, Anchorage Capital appointed their Managing Director, Phillip Cave, as Chairman of Dick Smith’s board). The point of doing so is to ensure that the firm is able to achieve the upside potential they identified during their acquisition process.
Private equity’s ownership position in their investments necessitates that they take a greater role in the operational and strategic side of their acquisitions. This is the main point of differentiation between PE and investment banks, who are largely facilitators and hedge funds who are largely non-ownership based investors.
How do you pursue a career in Private Equity?
It is increasingly rare for Private Equity firms to hire graduates straight from University. Most firms will look to make experienced hires from investment banks or specialist investment firms within their industries of operation. Generally speaking, the best strategy for employment within Private Equity is to gain some graduate experience within finance and then look to move laterally after 2-3 years, into an analyst position.
The question of whether private equity is a villain or hero is overblown in the mainstream media. The industry has a valid role in finance and is, on most occasions, largely successful in doing so. However, like all other finance streams, it is also prone to errors in judgement and operation. The question is likely to remain for some time and EFS has no desire to add to the conjecture. Hopefully armed with this article, you will now be able to understand the practical sides of each argument and come to an educated viewpoint one way or the other.